Question

Effect of different order quantities on ordering costs and carrying costs, EOQ. Koala Blue, a retailer of bed and bath linen, sells 234,000 packages of Mona Lisa designer sheets each year Koala Blue incurs an ordering cost of $81 per purchase order placed with Mona Lisa Enterprises and an annual carrying cost of $11.70 per package. Liv Carrol, purchasing manager at Koala Blue, seeks your help: She wants to understand how ordering and carrying costs vary with order quantity.

1. Complete the preceding table for Liv Carrol. What is the EGG? Comment on your results.

2. Mona Lisa is about to introduce a Web-based ordering system for its customers. Liv Carrol estimates that Koala Blue’s ordering costs will be reduced to $49 per purchase order. Calculate the new EGG and the new annual relevant costs of ordering and carrying inventory,

3. Liv Carrol estimates that Koala Blue will incur a cost of $2,000 to train its two purchasing assistants to use the now Mona Lisa system. Help Liv Carrol present a case to upper management showing that Koala Blue will be able to recoup its training costs within the first year of adoption.

Answer 1

Effect of different order quantities on ordering costs and carrying costs, EOQ.

1.

The economic order quantity is 1,800 packages. It is the order quantity at which carrying costs equal ordering costs and total relevant ordering and carrying costs are minimized. 

We can also confirm this from direct calculation. Using D = 234,000; P = $81 and C = $11.70

It is interesting to note that Koala Blue faces a situation where total relevant ordering and carrying costs do not vary very much when order quantity ranges from 1,500 packages to 2,700 packages.

2.         When the ordering cost per purchase order is reduced to $49:

The EOQ drops from 1,800 packages to 1,400 packages when Koala Blue’s ordering cost per purchase order decreases from $81 to $49.

The total new costs of ordering and carrying inventory = $8,190  2 = $16,380

3.    As summarized below, the new Mona Lisa web-based ordering system, by lowering the EOQ to 1,400 packages, will lower the carrying and ordering costs by $4,680. Koala Blue will spend $2,000 to train its purchasing assistants on the new system. Overall, Koala Blue will still save $2,680 in the first year alone.

Total relevant costs at EOQ (from Requirement 2)	$16,380
Annual cost benefit over old system ($21,060 – $16,380)	$ 4,680
Training costs	2,000
Net benefit in first year alone	$ 2,680

Total relevant costs at EOQ (from Requirement 2)	$16,380
Annual cost benefit over old system ($21,060 – $16,380)	$ 4,680
Training costs	2,000
Net benefit in first year alone	$ 2,680